Monopolistic Competition And Market Structure

Industries are traditionally divided into four categories depending to the degree of competition that exists between the firms within the industry. Perfect competition exists when there are many firms competing with none of them has the power to influence the price. At the other extreme is monopoly, which happens when a single company owns all or nearly all of the market for a given type of product or service. There is a barrier to entry into the industry that allows the single company to operate without competition. The monopolist will often produce a volume that is less than the amount which would maximise social welfare. Next to perfect competition there is monopolistic competition, where there are several sellers each produce similar, but slightly differentiated products with each producer can set its price and quantity without affecting the marketplace as a whole. Next to monopolistic competition comes oligopoly, where there are only a few firms and where entry of new firms is restricted (www.investorwords.com, 2010).

A monopolist produces a smaller quantity and sells it at a higher price. This is the reason usually given when one attacks monopolists. Monopolists raise the price and restrict production compared with a perfectly competitive situation. This difference between monopoly and competition arises not because of differences in costs but rather because of differences in the demand curves facing the individual firms. The monopolist has monopoly because it faces a downward-sloping demand curve (Sloman, 2001).

If monopolisation results in higher marginal cost, then the cost to society is great. However, if monopolisation results in cost savings, then the cost to society of monopolies is small. If the monopolist can enjoy scale economies and thus operate on a lower short-run marginal cost curve, it can produce cost savings to set against the deadweight welfare loss (Anderton, 2000).

A further point is that the monopolist may actually charge a price lower than the profit-maximising price for its product or service. It does so because it will be drawing less attention from government and its customers if its price does not appear “excessive”.

Another advantage of monopoly is the development of new products. Monopolists can afford to take a long term view and finance expensive and uncertain research and development programmes. The society will benefit from the new products. The monopolist may benefit in the short term, but competition could force prices down. An example is the ball-point pen which was patented in 1945. In 1946, it cost 80 cent to make and was sold at $12.95. By 1948, the pen cost only 10 cents to make and was selling at 39 cents.

With monopolistic competition the goods that are produced by the firms in the industry are similar and slight differences often exist. Therefore, firms operating in monopolistic competition are extremely competitive but each has a small degree of market control. The real world is full with monopolistic competition, such as retail trade, including restaurants, clothing stores, and convenience stores (Sloman and Sutcliffe, 2004).

The four characteristics of monopolistic competition are; large number of small firms; similar, but not identical products; relatively good, but not perfect resource mobility; and extensive, but not perfect knowledge.

A monopolistically competitive industry contains a large number of small firms that are relatively competitive with very little market control over price or quantity. Each firm has hundreds, if not thousands of potential competitors.

Each firm sells a similar, but not absolutely identical, product. These products are close substitutes for one another but not perfect substitutes. It is essential that each product satisfies the same basic want or need. The products are treated as similar, but different by the buyers.

Each firm is relatively free to enter and exit an industry as there are not many restrictions. Firms in monopolistic competition are different from those in perfect completion as they are not “perfectly” mobile. However, they are largely unrestricted by government rules and regulations, start-up cost, or other substantial barriers to entry.

In monopolistic competition, buyers do not have extensive knowledge, but they have relatively complete information about alternative prices and about product differences, brand names, etc. However, each seller has relatively complete information about production techniques and the prices charged by their competitors (Sloman, 2001).

Firms operating in monopolistic competition could earn abnormal profits, normal profits or make a loss s shown in Figures 1 – 3 below.

The price charged by a monopolistically competitive firm can be greater than its marginal cost. The inequality of price and marginal cost violates the key condition for efficiency, i.e. resources are not being used to generate the highest possible level of satisfaction. Because a monopolistically competitive firm has control over a small slice of the market, it faces a negatively-sloped demand curve and price is greater than marginal revenue, which is set equal to marginal cost when maximising profit. But the monopolistically competitive firm tends to be less inefficient than other market structures, especially monopoly. For example, a monopoly that charges a £10 price while incurring a marginal cost of £2 creates a serious inefficiency problem. On the other hand, the inefficiency created by a monopolistically competitive firm that charges a £5 price while incurring a marginal cost of £4.95 is substantially less.

Figure 1. Abnormal profits happen when average revenue (AR) is more than average cost (Source: http://www.revisionguru.co.uk/economics/monopolist.htm, 2010).

Figure 2. Normal profits happen when average revenue (AR) equals to average cost (Source: http://www.revisionguru.co.uk/economics/monopolist.htm, 2010).

Figure 3. Losses happen when average revenue (AR) is less than average cost (Source: http://www.revisionguru.co.uk/economics/monopolist.htm, 2010).

To summarise, freedom of entry and the lack of long run abnormal profits under monopolistic completion are likely to keep prices down. Competition may keep prices lower than under monopoly.